Analysis: Markets to hold U.S. feet to fire as default threatens

By Steven C. Johnson and Richard Leong

NEW YORK (Reuters) - Global financial markets have been more than patient throughout this summer's struggle over raising the U.S. debt ceiling. That patience may run out on Monday.

With the August 2 deadline a week away and an agreement still in question after talks involving U.S. lawmakers and President Barack Obama's administration faltered this weekend, investors may come to work facing the real possibility of a U.S. default and the loss of the country's prized AAA credit rating.

If the notion that the game of "chicken" over the nation's debt is going to end badly takes hold, Treasuries and the dollar could come under heavy selling pressure, driving up interest rates, damaging business confidence, and weakening an already fragile U.S. economy even more.

A slide in the bond market could trigger a wave of selling elsewhere, too, with stocks, money market mutual funds and higher risk assets elsewhere in the world all vulnerable as deepening problems in the U.S. would threaten to damage the global economy.

The kind of nightmare that keeps investors awake at night is a repeat of the chaos in 2008, when Congress' failure to authorize a $700 billion bank bailout sparked a global markets meltdown.

A substantive deal that cuts some $3 trillion to $4 trillion from the deficit over the next 10 years would be met favorably by investors, but that will tough to reach now.

A two-step plan being pushed by Republicans to give the government enough borrowing authority to make it through the year while lawmakers work on long-term deficit reduction could allay some fears but could still lead to a ratings downgrade.

Standard & Poor's has said it might still cut the United States to AA if lawmakers embrace a short-term fix that lifts the debt ceiling but doesn't address long-term fiscal issues.

Many investors are still holding out hope for a debt deal even it were to occur a second before the clock strikes at midnight on August 2.

To be safe, though, trading and investment houses have built up their cash holdings and reduced their exposure to stocks and risky assets in case the U.S. does default.

LONG BOND, DOLLAR VULNERABLE

Throughout the debate, bond yields have held near historic lows, with the benchmark 10-year note trading below 3 percent. Investors say that reflected belief that squabbling politicians would not let things escalate to the point of actually risking a default.

"We believe Winston Churchill characterized the U.S. well when he said, 'You can always count on Americans to do the right thing after they've tried everything else,'" said David Kotok, chairman and chief investment officer at Cumberland Advisors in Vineland, New Jersey.

But if that's wrong, he said "the markets will experience a horrible shock. The unthinkable will have occurred."

A default or downgrade would tarnish the full faith and credit of the United States and raise questions about the country's ability to get its long-run finances under control.

That's why analysts and investors expect the 30-year bond to sustain the most damage, sending its price sliding and the yield climbing.

"Playing Russian roulette with the bond market is a zero sum game. It is history's rule rather than the exception that the outcome of a default will be dramatically higher interest rates for all Americans and a generation-defining shift that will make job creation significantly more difficult," Cooper said.

What's worse, a dramatic sell-off in Treasuries could threaten this week's auctions, where the government aims to sell $99 billion worth of debt. Gridlock in Washington has already spooked foreign investors including central banks, who hold half of the $9.3 trillion in publicly held Treasuries.

Treasury data released late Friday showed foreign investors including overseas central banks cut back their purchases of U.S. government debt at auctions earlier this month.

The dollar would likely suffer in that scenario, too, mostly against the Swiss franc and yen, analysts said.

"In the current circumstances, there is no reason to increase your holding of U.S. dollars," said BNY Mellon strategist Michael Woolfolk.

"HIGHLY DETRIMENTAL"

Overseas markets would also get rattled if investors start unloading higher-yielding but higher-risk stocks and currencies in Asia, Latin America and elsewhere.

"If not reversed within the next few days through crisis negotiations, this breakdown will be highly detrimental to the already-fragile health of both the U.S. and global economies," said Mohamed El-Erian, co-chief investment officer at Pacific Investment Management Co., which oversees $1.2 trillion,

Ironically, short-dated Treasuries could rally because there are simply so few alternative liquid investments that can compete with the U.S. bond market's size and depth.

Investors said a substantive deal - something along the lines of $3 trillion to $4 trillion in savings over a decade - would probably spark a relief rally across assets, boosting stocks and the dollar the most.

And, some said predictions of Armageddon were off base.

Brian Belski, chief investment strategist at Oppenheimer and Co, said retail investors are nervous but noted that the strong corporate balance sheets and U.S. equity performance would keep attracting money into the U.S. economy.

"I think everyone needs to take a deep breath about any potential downgrade," said Brian Belski, chief investment strategist at Oppenheimer and Co. "If it happens it will likely be a short-term phenomenon and ultimately provide an opportunity to buy some stocks at lower prices."

(Reporting by Richard Leong, Steven C. Johnson, Jennifer Ablan, Daniel Bases, Emily Flitter and David Gaffen; Writing by Steven C. Johnson; Editing by Martin Howell)